Bryan Caplan  

Do Wage Cuts Reduce Communal Purchasing Power?

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I'm frankly stunned that Krugman would approvingly quote the following passage from Keynes:
[I]f a particular producer or a particular country cuts wages, then, so long as others do not follow suit, that producer or that country is able to get more of what trade is going. But if wages are cut all round, the purchasing power of the community as a whole is reduced by the same amount as the reduction of costs; and, again, no one is further forward.
Suppose I cut my cleaning lady's pay by $10 per week.  What happens to the "purchasing power of the community as a whole"?  Her purchasing power clearly falls by $10.  But my purchasing power just as clearly rises by $10.  The net effect, assuming no change in behavior, is -$10+$10=$0. 

And that's just nominal purchasing power.  When the price of cleaning services goes down, and all other prices stay the same, real purchasing power of the community is actually slightly higher.

Krugman's next paragraph gratifyingly acknowledges this basic principle for creditor-debtor contracts:
And Fisher pointed out in 1933 that a general fall in wages and prices actually makes things worse, by making debtors poorer in real terms; true, creditors are made richer, but because debtors are more likely to cut spending than creditors are to increase it, the overall effect is to deepen the depression.
But the same goes for labor contracts, too.  In both cases, the sole Keynesian mechanism at work is differences in the marginal propensity to spend.  All talk about "reductions in communal purchasing power" is a red herring.

Consider: By Keynes and Krugman's reasoning, mandating a 50% pay raise throughout the economy would be a fool-proof way to raise communal purchasing power by 50%.  It's not.  Employers foot the bill, and their purchasing power falls just as much as workers' rises.  Assuming, of course, that they don't hire fewer workers or declare bankruptcy.  The interaction between income distribution and marginal propensity to consume could outweigh these effects, but I see no reason to think they would.

There is plenty of evidence that nominal wages are downwardly rigid.  There is plenty of evidence that government is far from the sole cause of this rigidity.  Basic labor economics says that if Aggregate Demand falls and nominal wages are rigid, you'll get unemployment.  Why can't Krugman stick to these simple truths, instead of maligning wage flexibility as the road to ruin?



COMMENTS (10 to date)
DJ102010 writes:

Bryan, you write "...but I see no reason to think they would." I think a better way of putting that would be "the burden of proof for that claim lies with Keynes and Krugman."

That is, it's not your lack of imagination that's the issue here. It's that Krugman makes a conclusion that requires a supporting argument.

honeyoak writes:
And Fisher pointed out in 1933 that a general fall in wages and prices actually makes things worse, by making debtors poorer in real terms
This statement is empirically false. If the debtor defaults, they may actually be better off. Moreover, there is no debtor class. All economic agents are debtors or creditors to some extent. What he should have actually said is:
And Fisher pointed out in 1933 that a general fall in wages and prices actually makes things worse, by making specific debtors poorer in real terms
Paul writes:

Krugman did link to a paper he co-authored in 2010 in the post. The blog comment was obviously dumbed down for the masses, so why not argue with his real argument? Here's the abstract:

In this paper we present a simple New Keynesian style model of debt driven slumps that is, situations in which an overhang of debt on the part of some agents, who are forced into rapid deleveraging, is depressing aggregate demand. Making some agents debt constrained is a surprisingly powerful assumption: Fisherian debt deflation, the possibility of a liquidity trap, the paradox of thrift, a Keynesian type multiplier, and a rationale for expansionary fiscal policy all emerge naturally from the model. We argue that this approach sheds considerable light both on current economic difficulties and on historical episodes, including Japan’s lost decade (now in its 18th year) and the Great Depression itself.

Daniel Kuehn writes:

Perhaps I'm missing something, but the Keynes quote is not considering a case where some peoples' wages get cut and some don't. So why is the counter-argument structured in that way?

When you look at an individual labor contract all that you say here rings true, but if you're talking about an economy-wide nominal wage cut you're talking about an economy-wide fall in nominal spending.

This sentence: "When the price of cleaning services goes down, and all other prices stay the same, real purchasing power of the community is actually slightly higher."

Seems to make it pretty clear that you and Krugman are talking about wholly different phenomena.

Daublin writes:

I find Krugman's openiling line jarring: "[I]f a particular producer or a particular country cuts wages...".

I understand what it means for a producer to cut wages, at least for a small business. What does it mean for a country to cut wages, though?

steve writes:

I think you have misread this Bryan. If I cut the wages at my firm, I can then offer our services or product at a lower price. I should be able to capture more of the ongoing trade. That is not, I think, a controversial claim. Note that he says nothing about purchasing power in this part of the statement. In the case where everyone cuts wages, no one capture more trade as no one creates a comparative advantage by cutting wages. I think you might more correctly think about this in terms of selling power, but purchasing power is also true.

I think you are making an inference about purchasing power that I dont think exists in the first part of the quote.

Steve

Ted writes:

Suppose the community consists of 1000 Bryan Caplans and 1000 Cleaning Ladies and the Bryan Caplans succeed in cutting the Cleaning Ladies wages. The Cleaning Ladies each lose 10 dollars of purchasing power and the Bryan Caplans each gain 10 (as compared to the previous situation). Certainly if we end the story here aggregate nominal income would have fallen by $10,000. But what really happens depends on what the legion of Bryan Caplans do with their savings. The Bryan Caplans can either A)Hoard the money as a hedge against risk [ tangent: if purchasing insurance from an insurance company counts to aggregate spending does self-insuring through holding cash balances likewise count? If not, why?] B) Use the stack of money to prop up wobbly coffee tables or C) Assuming not all Bryan Caplans have the same preferences, some Bryan Caplans could pay the other Bryan Caplans to produce output not currently being produced, thus expanding the categories of workers from 1 to 2 and the range of output from cleaning services to cleaning services plus other services.

So let us suppose that half the Bryan Caplans agree to pay the other half $10 to mow their lawn. At this point 500 Lawn-Mowing Bryan Caplans have $20 more than the initial situation, 500 non-Lawn-Mowing Caplans have exactly the same, and the cleaning ladies are still $10 each the worse off. At THIS point aggregate spending is only $5000 less than the initial situation. But again, what happens to aggregate spending going forward depends upon what those 500 Lawn-Mowing Caplans do next. Likewise, one would also have to examine the same causal chain resulting from the reduction in purchasing power to the Cleaning Ladies.

Or much more succinctly: "The interaction between income distribution and marginal propensity to consume" is what is at work here. The results of a nominal wage cut on aggregates revolves entirely around WHO gets the savings (loses) and WHAT they spend (don't spend) it on as the money flows from one person to another.

Or at least that's just the way I thought about it.

Hunter writes:

Fisher's quote should be more like debtors are more likely to declare bankruptcy hurting creditors and reducing the amount of credit money in the system which hurts everyone.

Philo writes:

“[B]ecause debtors are more likely to cut spending than creditors are to increase it, the overall effect [of impoverishing debtors while enriching creditors] is to deepen the depression.” The ‘because’ clause here is true if ‘spending’ means *consumption spending*, but not if it covers also spending on capital goods. Impoverishing debtors [mostly poor people] while enriching creditors [rich people] would cause a shift in demand from consumer goods to capital goods, but it would not *deepen the depression*.

pyroseed13 writes:

I see that some, notably Daniel Kuehn, have raised the argument that an employer cutting his employees' wages is different from a "community" of employers cutting wages. But what exactly does it mean for a "community," or as Krugman puts it, a "country," to cut wages? Presumably there is no way for employers to collectively cut wages, and the need to cut wages at all was necessitated by a decline in sales i.e. nominal spending. So employers are merely adjusting to a new equilibrium.

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